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Engineering Economics: A Prologue

1.1 Introduction
Engineering economics is concerned with the formulation, estimation and evaluation of
the economic outcomes of alternatives that are available to accomplish a defined purpose.
Engineering economics can be defined as a collection of mathematical techniques that
simplify economic comparison. Engineers use the knowledge of engineering economics in
analyzing, synthesizing and drawing conclusions as they work on projects of different sizes. In
other words, the techniques and models of engineering economics assist engineers in making
decisions. The success of engineering and business projects is normally measured in terms of
financial efficiency. A project will be able to achieve maximum financial efficiency when it is
properly planned and operated with respect to its technical, social, and financial requirements.
Since engineers understand the technical requirements of a project, they can combine the
technical details of the project and the knowledge of engineering economics to study and
arrive at a sound managerial decision. The basic economic concepts that are essentially factors
to be considered in making economy studies are briefly discussed in this chapter.

1.2 Introduction to Economics

Economics is about choice and is at the heart of all decision-making. Individuals, businesses
and governments are all faced with making choices in situations where resources are scarce.
The principles of economics are applied to a wide range of fields, including business, finance,
administration, law, local and national government and, indeed, in most of the aspects of
everyday life. While studying economics, we examine topics of obvious importance to the
well-being of all humans. Increasingly, policy debates in all areas are being cast in economic
terms and understanding most of the current issues requires an understanding of economics.

1.3 Need to Study Economics

Studying economics gives insights into the general environment of resource allocation
decisions, opportunity costs and project evaluation which are crucial in many areas. Often,
these insights are not obvious, and can be counter-intuitive to those who don’t apply economic
reasoning.
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Economics studies economic activities: Humans perform various types of activities in their daily
lives like religious, social, political and economic activities. Economics does not deal with all
of them. But humans spend the maximum time on economic activities. Therefore, economics
is a subject which studies economic activities of humans.
Study of wants Æ efforts Æ wealth Æ satisfaction: Every human being is doing some business
and every human being has some wants and these wants are unlimited. To fulfill these wants
a person does efforts, by doing efforts he gets wealth and with this earned wealth he satisfies
his wants.
Study of human behavior with relation to ends and scarce means: As long as a person is alive, his wants
go on increasing. But the person cannot fulfill all the wants. The reason is that the resources
required to fulfill these wants are limited. Besides the fact of scarcity of resources, we also
find that resources have alternative uses. Hence economics is a subject which studies human
behavior as a relationship between ends and scarce means which have alternative uses.
Economics studies problem of choice: Scarcity and choice go together. If things were available in
abundance, then there would have been no problem of choice; the point is that “problems of
choice” arise because of scarcity. We can summarize the basic economic problems by means
of a chart shown in Fig. 1.1.
Economic problem

Ends Means

Unlimited Limited

Differ in urgency Alternative uses

Problem of choice making

or
Problem of decision making

Figure 1.1 Summary chart of basic economic problems

1.4 Circular Flow of Economic Activities

Circular Flow of economic activities is a flow which has neither a beginning nor an end.

Basic economic activities An economic activity is a systematic endeavor to satisfy a material

need. Material needs are the needs for goods and services. We know that human wants are
unlimited. We are always busy satisfying one want or the other. “The vital processes or
essentials functions like production, consumption, investment and distribution, as shown in
Fig. 1.2, are those economic activities which are necessary for the working or survival of an
economy.”
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Figure 1.2 Vital economic activities

Production: Production as a process of creation of utility or value in goods or services (or both).
Anatol Murad defined this as: “Production may be defined as the creation of utilities.”
Factors of Production: Factors of production are the essential elements which cooperate with
one another in the process of production. The various factors of production are shown in
Fig. 1.3.
Land: It is that factor of production which is available to humankind as a free gift of nature.
Labor: It is the physical or mental effort of human beings in the process of production. Services
of a doctor, lawyer, teacher, worker in the factory, all constitute labor.

Figure 1.3 Factors of production

Capital: Capital is man-made material and is a source of production. It consists of the part of
production which is used for further production.
Entrepreneurship: Entrepreneurship refers to the skills of the entrepreneur:
(a) to organize business
(b) to undertake risks of business
Consumption: In economics, consumption has a special meaning; it means the use of or utility
of goods and services for the direct satisfaction of individual and collective wants.
For example: When you eat bread, you are using up the want-satisfying capacity of bread, that
is, its utility. Different types of consumption are shown in Fig. 1.4.

Figure 1.4 Types of consumption

Individual Consumption: It is that consumption which leads to the final satisfaction of the wants
of an individual.
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Collective consumption: It is that consumption which leads to the final satisfaction of collective
wants. For example: Uses of roads, dams, bridges or parks.
Investment or Capital formation: Investment or capital formation is the third vital process or
essential activity of an economy. “Investment is that part of production during a year which is
not consumed but saved as capital formation for further production.” The excess of production
over consumption in an accounting year is called capital formation or investment.
I=Y−C

I = Investment, Y = Income, C = Consumption.

Some fundamental relationships:
1. Production = Consumption + Investment
Q=C+I
Q = Production
2. Income = Consumption + Saving
Y=C+S
S = Saving
3. Saving ∫ Investment
S=I
Q=C+I
or         Y = C + T (∵ Q = Y)
and Y=C+S
C+S=C+I
∵ S∫I

In other words, the circular flow of income can be explained using the flowchart shown in
Fig. 1.5.

Production

Circular
Distribution flow of Investment
income

Consumption

Figure 1.5 Circular flow of income

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The flow of production, income and expenditure never stops. It is a circular flow without a
beginning or an end. Production generates income, income generates demand for goods and
services, and demand generates expenditure on the goods and services which leads to their
production, so that the circle of production, consumption and expenditure always continues.

Performance of economic activities Economic activities are undertaken by the following

sectors of the economy:
Household Sector: This sector includes households, who consumes goods and services, and
provides factor services.
Firms or Business Sector: The firm produces goods and services by using factor services.
Government Sector: The government sector undertakes both consumption as well as
production.

Flow of income There are two types of flow of income in an economy:

 Real flow of income
 Monetary flow of income
Real flow of income: It involves the flow of factor services from the household sector to the
producing sector and the corresponding flow of goods and services from producing sector to
household sector. This is explained in Fig. 1.6.

Figure 1.6 Real flow of income

Monetary flow of income: It refers to the flow of factor income e.g.: rent, interest, profit, wages
and so on from the producing sector to the household sector as rewards for their factor services.
The households spend their income on the goods and services produced by the producing
sector. According to it, the money flows back to the producing sector. Fig. 1.7 explains this.
Factor Payments

Household Monetary Producing

sector flow sector

Consumption expenditure
on goods and services

Figure 1.7 Monetary flow of income

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1.5 Circular Flow of Income in Different Sectors

Circular flow of Income is analyzed under three different situations based on certain simplifying
assumptions:

Two sector model It studies the circular flow of Income between the household and
producing sector on the assumption that there are only two sectors in the economy (Fig. 1.8).

Figure 1.8 Two sector model

Three Sector Model It refers to the study of the circular flow of income among:
(i) Household sector
(ii) Producing sector
(iii) Government sector
Here the assumption that the economy comprises of these three sectors. It is a closed economy
(Fig. 1.9).

Figure 1.9 Three sector model of circular flow of income

Four Sector Model It studies the study of the circular flow of income among:
(i) Household sector
(ii) Producing sector
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(iii) Government sector

(iv) Foreign sector or rest of the world.
In other words, it studies the flow of income in an open economy. The model studies all
sectors of the economy, dropping all the simple assumptions made earlier (Fig. 1.10).

Figure 1.10 Four sector model

1.6 Demand Theory

In economics, we are concerned with the demand for a commodity faced by a firm. Demand
is regarded as the lifeline of a business enterprise. Demand analysis seeks to identify and
measure the forces that determine sales.

Meaning of demand In ordinary language, the terms need, desire, want and demand are
used in the same sense. But in economics, all these terms have different meanings. For instance,
a sick child needs medicine, a worker desires to have a car, but such needs and desire do not
constitute demand.
Demand is the want of a person, which will become demand when he is ready to buy the
goods at a given price and at a given point of time. So demand may, then, be defined as the
quantity of a commodity which a consumer is willing and able to purchase at a given price,
during some specific period of time.
There are seven essentials of demand:
1. Desire for a commodity.
2. Capacity to pay for it.
3. Willingness to pay for it.
4. Quantity bought and sold.